Questions on a bank's operations

Posted by 2.7182818284590... on October 23, 2008, 2:25 pm

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I have a question: Since deposits are liabilities and mortgages/loans
are assets, then isn't a highly leveraged bank a *GOOD* tihng? Here
are two examples:
Bank A: It has $1M in total assets, of which $100K is equity, and
$900K is in depositor's accounts which is a liability. The leveraged
position here is 10x.

Bank B: It has $1M in total assets, of which $500K is in equity, and
$500K is in depositor's accounts which is a liability. The leveraged
position here is 2x. However, this sounds like a stronger balance
sheet, but keep in mind, they have far more in outstanding mortgages/
loans that they've financed. This is a bad thing.

On the other hand, Bank A has far less in outstanding mortgages/loans,
and therefore, they are less "margined" or leveraged.

I'm confused. Which bank is in a better predicament, and what ratio
would show that it's in a better predicament?

Posted by Rod Speed on October 23, 2008, 3:26 pm

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> I have a question: Since deposits are liabilities and mortgages/loans

> are assets, then isn't a highly leveraged bank a *GOOD* tihng? Here

> are two examples:

> Bank A: It has $1M in total assets, of which $100K is equity, and

> $900K is in depositor's accounts which is a liability. The leveraged

> position here is 10x.

> Bank B: It has $1M in total assets, of which $500K is in equity, and

> $500K is in depositor's accounts which is a liability. The leveraged

> position here is 2x. However, this sounds like a stronger balance

> sheet, but keep in mind, they have far more in outstanding mortgages/

> loans that they've financed. This is a bad thing.

> On the other hand, Bank A has far less in outstanding mortgages/loans,

> and therefore, they are less "margined" or leveraged.

> I'm confused. Which bank is in a better predicament, and what ratio

> would show that it's in a better predicament?

The problem with leverage has nothing to do with assets and liabilitys.

The problem is that leverage amplifys the penaltys and benefits of correct
financial decisions.

So if the mortgages are toxic debt in the sense that they will see a lot of
defaults, they
arent assets and become liabilitys when you cant get rid of the mortgaged
propertys.

Posted by 2.7182818284590... on October 23, 2008, 9:09 pm

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> > I have a question: =A0Since deposits are liabilities and mortgages/loan=

> > are assets, then isn't a highly leveraged bank a *GOOD* tihng? =A0Here

> > are two examples:

> > Bank A: =A0It has $1M in total assets, of which $100K is equity, and

> > $900K is in depositor's accounts which is a liability. =A0The leveraged

> > position here is 10x.

> > Bank B: =A0It has $1M in total assets, of which $500K is in equity, and

> > $500K is in depositor's accounts which is a liability. =A0The leveraged

> > position here is 2x. =A0However, this sounds like a stronger balance

> > sheet, but keep in mind, they have far more in outstanding mortgages/

> > loans that they've financed. =A0This is a bad thing.

> > On the other hand, Bank A has far less in outstanding mortgages/loans,

> > and therefore, they are less "margined" or leveraged.

> > I'm confused. =A0Which bank is in a better predicament, and what ratio

> > would show that it's in a better predicament?

> The problem with leverage has nothing to do with assets and liabilitys.

> The problem is that leverage amplifys the penaltys and benefits of correc=

t financial decisions.

> So if the mortgages are toxic debt in the sense that they will see a lot =

of defaults, they

> arent assets and become liabilitys when you cant get rid of the mortgaged=

propertys.- Hide quoted text -

> - Show quoted text -

I totally understand the principle of leverage and how it accelerates
bankruptcy. My question arised after reading about American and
European banks and their capital structure on http://valtenbergs.com/archiv=
es/601
.

They compared European banks, which had a very high leverage ratio
when compared to American banks. However, I would think that a bank
which has a lot of depositiors and very few borrowers is a more
prudent bank. Of course, they probably aren't making much money.

According to my calculations, the HIGHER the leverage ratio (i.e.
(liabilities + equities)/(equities) ), the more solvent is the bank.
All depositors are liabilities, remember. Moreover, assets is always
equal to liab. + equities.

Posted by Rod Speed on October 23, 2008, 10:26 pm

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>>> I have a question: Since deposits are liabilities and

>>> mortgages/loans are assets, then isn't a highly leveraged

>>> bank a *GOOD* tihng? Here are two examples:

>>> Bank A: It has $1M in total assets, of which $100K is

>>> equity, and $900K is in depositor's accounts which is

>>> a liability. The leveraged position here is 10x.

>>> Bank B: It has $1M in total assets, of which $500K is in equity, and

>>> $500K is in depositor's accounts which is a liability. The leveraged

>>> position here is 2x. However, this sounds like a stronger balance

>>> sheet, but keep in mind, they have far more in outstanding

>>> mortgages/ loans that they've financed. This is a bad thing.

>>> On the other hand, Bank A has far less in outstanding mortgages/loans,

>>> and therefore, they are less "margined" or leveraged.

>>> I'm confused. Which bank is in a better predicament, and

>>> what ratio would show that it's in a better predicament?

>> The problem with leverage has nothing to do with assets and liabilitys.

>> The problem is that leverage amplifys the penaltys

>> and benefits of correct financial decisions.

>> So if the mortgages are toxic debt in the sense that they will see a lot of

defaults, they

>> arent assets and become liabilitys when you cant get rid of the mortgaged

propertys.

> I totally understand the principle of leverage and how it accelerates

bankruptcy.

> My question arised after reading about American and European banks and their

capital structure on

> http://valtenbergs.com/archives/601

> They compared European banks, which had a very high leverage ratio

> when compared to American banks. However, I would think that a bank

> which has a lot of depositiors and very few borrowers is a more prudent bank.

Its not the number of each that matters, its the amount of money deposited and
lent.

> Of course, they probably aren't making much money.

Indeed.

> According to my calculations, the HIGHER the leverage ratio (i.e.

> (liabilities + equities)/(equities) ), the more solvent is the bank.

Thats not right.

> All depositors are liabilities, remember.

It much more complicated than that, particularly when runs on banks happen
because
the depositors have decided that you have a lot of toxic debt that you arent
admitting to.

> Moreover, assets is always equal to liab. + equities.

Its much more complicated than that too, particularly when you have to mark to
market.

Posted by Paul Thomas, CPA on October 23, 2008, 4:06 pm

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>I have a question: Since deposits are liabilities and mortgages/loans

> are assets, then isn't a highly leveraged bank a *GOOD* tihng?

If, and only if the assets (loans) are valid and presented on the financial
statements at the lower of cost or market. So that $100,000,000 loan you
made on an asset that is now worth $500,000..........people want to know.

Otherwise, if the loans are all good - being paid
or if the loan collateral is good - greater than the loan amount.

What has happened is the loans are not being repaid and the banks are
finding the colateral is not worth the loan amount.